Dodd-Frank compliance forces changes in CTRM vendor-provided capabilities

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Paul Campbell, Tom Lochbichler, and Simit Dhawan, Deloitte & Touche LLP, Houston

The Dodd-Frank Wall Street Reform and Consumer Protection Act has stated goals of lowering risk, promoting transparency, and protecting the American public. Nonetheless, the impact of Dodd-Frank may not be fully understood for years. Certainly, the regulatory impact is likely to be different for the financial service industry (FSI) compared to the energy industry.

While almost the full scope of Titles I – XVI of Dodd-Frank, as understood today, are applicable to large financial institutions, much of the focus has been on sections of Title VII pertaining to use of swaps and regulation by the Commodity Futures Trading Commission (CFTC) that will have the greatest impact on energy companies. There is concern as to what the future holds for energy and commodity companies dependent upon solutions provided by commodity transacting and risk management (CTRM) vendors – these are the systems that will contain the required data for DoddFrank compliance.

As an industry, CTRM vendors have traditionally trailed those focused on FSI due to the larger, more progressive market that is also much more heavily regulated. It is this regulation and definition of compliance requirements that can be translated into functional requirements for industry participants. CTRM vendors have the added challenge of providing functionality to manage physical commodities and logistics, the complexities of which are unique.

Deloitte has developed an informed view on the path forward based on the benefit of a CTRM practice established more than 15 years ago and a broad view of the energy industry that emerges from serving more than 90% of the market. This informed perspective also comes from our understanding of the impact of regulatory change from our Tax and Enterprise Resource Planning (ERP) practices.

We see a likely evolution in CTRM vendor-provided capabilities for Dodd-Frank compliance, which may follow the four stages and timings outlined below. This view on CTRM vendor evolution is based on similar regulatory regime changes related to SarbanesOxley (SOX), derivative accounting (FAS 133/ASC 815), and even more recent issues related to gas price reporting and "Shipper Must Have Title".

System capabilities for Dodd-Frank compliance over the next five years will likely progress from Ad-Hoc, to Fragmented, and then Comprehensive and Integrated. As the rules related to swap transacting, including issues like position limits, end-use exception, etc., have not yet been finalized by the CFTC, energy companies' response will similarly progress from stages that can be characterized as "Wait and See," to "Maintain Awareness," and then to "Proactively" addressing the combined business and technology solutions to meet compliance.

Ad-Hoc

While a small number of energy market participants are beginning to address their expected Dodd-Frank requirements, the majority of companies have been slow to make investment decisions regarding changes to their underlying CTRM systems and processes, given the high degree of uncertainty with respect to the final rules.

Unlike the FSI industry, which has historically been more heavily regulated and is used to proactively responding to regulatory ambiguity, many energy companies have difficulty making investments or major decisions to address these issues until they become better understood. Similarly, CTRM vendors are unlikely to build functionality that addresses Dodd-Frank in any comprehensive manner thereby putting the burden on energy companies to develop internal ad-hoc solutions to meet their needs.

As in the past with SOX and derivative accounting requirements, the initial response to be in compliance with Dodd-Frank for most companies will be to develop interim solutions using Microsoft Excel. Similarly, the related business processes will likely be highly manual and ad-hoc.

In this environment, the challenge to build out these ad-hoc tools will be three-fold. First, from a data perspective, organizations will need to capture information not currently available in existing systems. Examples of this would include Dodd-Frank counterparty classification, obligation security method, and counterparty end-use exception election, as well as new internal deal classifications. There will also be an element of data cleansing so that the reported data is accurate. Companies that have transacting and counterparty information in numerous systems will have an especially large challenge with integrating and standardizing their data to meet these initial reporting requirements.

Dodd-Frank reporting requirements will not only impact energy companies' trading functions but also likely the fuel procurement, treasury and regulated hedging functions. Therefore, these ad-hoc solutions and processes will impact a large number of personnel.

Second, the data must be combined and transformed to correspond to Dodd-Frank reporting standards. Positions will need to be aggregated and classified, and new reporting views need to be developed which in many cases are currently not produced by companies today, and lack relevant business processes and controls.

Third, mechanisms for internal as well as external distribution need to be developed. This includes the governance, responsibility, and accountability for approving information. This will include approval of some reports by the board and senior executives as defined by the CFTC. The standards that companies would likely apply to these reports will be similar to those required for external financial reporting.

Internally, position limits, counterparty exposure, collateral, and trading behavior consistent with classification will need to be actively monitored and reported on. The standards that companies would likely apply to these reports will be similar to those required for normal operational reporting.

Early on, for most companies that have not gone through DoddFrank preparatory projects, the focus will be on rapidly responding to the new requirements and will not be on developing sustainable processes and compensating controls. Given the high bar of complying with Dodd-Frank, companies cannot afford to stop there. This will lead them into the next stage of maturity.

Fragmented

In the short to medium term, Dodd-Frank rules will continue to be refined. Energy companies will need to work towards not only enhancing and automating their previously constructed tools and processes, but also towards integrating these into their commercial and regulatory reporting organizations.

Dodd-Frank regulations will not stop at requiring merely periodic passive reporting. They will reach deeply into the business and will require an extremely high level of internal communication. For example, managing a counterparty's Dodd-Frank designation will be an on-going process. Further, companies that are able to proactively integrate Dodd-Frank requirements into their trading strategies will likely have a competitive advantage.

At this stage it is unlikely that off-the-shelf solutions, from specialized niche vendors or traditional CTRM vendors, will be available. Therefore, energy companies will need to enhance their previously developed ad-hoc processes and tools for sustainability while incorporating a higher degree of automation and workflow capabilities. These tools and processes will be more closely integrated into the commercial organizations and, as learning is internalized, a set of industry best practices will be developed. Excel-based tools will give way to data repositories that are integrated and linked to existing CTRM solutions and other business systems. New data capture will be automated to a greater extent than before.

Finally, commercial decisions will be strongly influenced be the Dodd-Frank reporting process. Energy companies will now be transitioning out of passively responding to an externally imposed reporting requirement, and into a stage where Dodd-Frank is becoming ingrained in their business. At the conclusion of this stage, a small number of niche vendors that have built custom solutions for energy companies for Dodd-Frank compliance tools may emerge.

Comprehensive

In the medium term, we expect that Dodd-Frank compliance requirements will continue to mature and be revised to meet the regulators' defined objectives. The associated reporting standards and related data requirements may continue to be impacted but to a lesser degree. However, energy companies will have a comprehensive view of the impact of Dodd-Frank on their organizations and will look to migrate their previously built tools and processes into enterprise systems.

We expect that the energy industry will favor CTRM vendors that provide automated Dodd-Frank compliance monitoring and reporting capabilities. Stability in Dodd-Frank rules and client demands will likely push major CTRM vendors to make significant investments to meet these needs. To this end, leading CTRM vendors will begin to offer Dodd-Frank compliance modules that are built through a) internal development efforts, b) joint development programs with their new or existing clients, c) expert advice from external consulting firms, and/or d) acquisitions or partnering relationships with niche vendors.

Historically, major CTRM vendors have used these strategies to build their capabilities to meet derivative accounting requirements. At this stage, energy companies may need to consider Dodd-Frank compliance capabilities of their CTRM vendors as they consider the continued use of these platforms.

We expect leading CTRM vendors and a smaller number of niche vendors to be leaders in offering Dodd-Frank compliance solutions at this stage. We could also see major ERP vendors enter the solutions market related to compliance by providing this functionality as a part of their solution suite.

Integrated

In the long term, we expect the Dodd-Frank rules and compliance requirements to stabilize for all impacted companies, including energy. This stage will continue the evolutionary process of CTRM vendors enhancing automation, workflow, and reporting capabilities of their Dodd-Frank compliance modules/capabilities. Major ERP vendors, like SAP and Oracle, may make Dodd-Frank compliance a major focus of enhancing their capabilities using similar strategies used by CTRM vendors.

Ultimately, ERP vendors may surpass CTRM vendor provided capabilities in this area. Recent history points to this trend where major ERP vendors have begun to offer robust governance, risk, and compliance (GRC) tools to automate SOX compliance. CTRM vendors have instead focused on expanding their capabilities to manage transactional and operational activities of multiple commodities and modes of transport. These vendors have not significantly enhanced their platforms to meet their client's SOX compliance needs as these have evolved over the years. ERP vendors' integrated approach to Dodd-Frank compliance, by incorporating best practices from FSI and energy companies, could provide integrated and robust industry standard solutions.

Conclusion

Energy companies should not rely on their CTRM vendors to provide Dodd-Frank compliance capabilities in the short to medium term, nor should they wait for niche vendors to emerge in this timeframe. Given the uncertainty in Dodd-Frank compliance requirements, expected evolution of these rules, and the investment required by vendors to build out these capabilities, we expect that energy companies will have to bear the burden of building out these solutions and related business processes internally. Nonetheless, CTRM and ERP vendor solutions will emerge in the medium to long term.

In conclusion, while some energy companies are waiting to see what the Dodd-Frank rules are before taking action, others are progressively moving towards maintaining awareness and understanding their potential impact. A smaller subset of companies are proactively addressing those impacts now.

At a minimum, all energy companies should ensure that their technology and business leadership teams are aware of the potential impact on their systems and processes. They should actively consider Dodd-Frank compliance requirements as they plan to upgrade their existing systems or initiate implementation of new CTRM applications in the next 24 months. Additionally, they should put placeholders in their 2012 budgets to account for potential technology and process impacts due to these regulatory changes.

Our previous experience of guiding energy companies through sweeping regulatory changes, especially trading, informs us that their total impact may be hard to discern but it is coming and, from a compliance standpoint, cannot be avoided.

About the authors

Click to EnlargePaul Campbell is a leader of the Deloitte & Touche LLP's Commodity Transacting and Risk Management practice and is also responsible for all Dodd-Frank services for energy companies. He brings both a business and technology background to solving risk management issues. Prior to joining Deloitte in 1999, he worked for a regulatory agency and several energy trading companies.

Click to EnlargeTom Lochbichler is the leader of Deloitte's Trading Technology practice, and has over 17 years of diverse experience delivering solutions across the Oil & Gas and Power & Utilities spaces. He has led numerous trading technology and regulatory projects at oil majors, including the design of a trade monitoring and surveillance platform, an assessment of a global regulatory compliance reporting platform, as well as a pilot of a communications surveillance application.

Click to EnlargeSimit Dhawan is a senior manager with Deloitte and Touche LLP's Energy and Resources practice. He is primarily focused on assisting his clients in designing and implementing transformational business and information technology solutions to manage and monitor risk around their trading and relational operational activities.

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